The Subsidy That Moved Both Curves
A regional government pays a $6 per unit subsidy to domestic producers of a fertiliser input that is also imported. Before the subsidy, the domestic price sits at the world price of $40, domestic supply is 20 000 tonnes, and domestic demand is 50 000 tonnes, with the gap imported. Six months after the subsidy begins, domestic supply at the unchanged world price rises to 32 000 tonnes, but the domestic price falls only to $38 because importers cut their margin to hold market share. Fertiliser users are concentrated in three downstream industries, and the government's stated goal was to reduce reliance on imports without raising costs for farmers. Treasury estimates the deadweight loss from the subsidy at $90 000 per year.
1. Using the figures given, assess whether the subsidy has achieved the government's stated goal. Show the direction of the import change and identify who captures the benefit.
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Import volume before: 50 000 − 20 000 = 30 000 tonnes. Import volume after: at $38, demand is not given directly, but the key movement is supply rising to 32 000 tonnes at the world price, so the importable gap narrows by roughly 12 000 tonnes before any demand response. Imports fall, so the quantity goal is partly met.
Who captures the benefit: the subsidy is paid to producers, but the price paid by users falls only $2 while the subsidy is $6. Producers retain the difference on each unit, and importers surrender margin to defend share. So farmers gain a little, producers and importers absorb the rest, and the taxpayer funds the $6.
Judgement: the goal is met only in a narrow quantity sense. Because the price fall is small relative to the subsidy, most of the transfer is captured upstream, and the $90 000 deadweight loss is not obviously justified by a 12 000-tonne import reduction. A stronger answer notes that the subsidy is poorly targeted: a tariff would have raised user costs, but a production subsidy with import competition leaks benefit to inframarginal producers.
2. The government considers replacing the subsidy with a tariff that would restore the pre-subsidy import volume. Compare the two instruments against the same goal, referring to the $90 000 figure.
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Subsidy path: cost to budget is the per-unit subsidy times subsidised output; the stated deadweight loss is $90 000 per year. Benefit is a lower domestic price and some import substitution, but the price effect is muted ($2 of $6) because importers compete the margin down.
Tariff path: a tariff raises the domestic price toward the world price plus the tariff, which does cut imports reliably because it removes the price advantage of imports. But it directly raises costs for the three downstream industries, which contradicts the 'without raising costs for farmers' constraint. The tariff also generates revenue rather than expenditure, so the fiscal sign flips.
Comparison: the two instruments fail different constraints. The subsidy protects farmers' costs but leaks benefit and costs $90 000 in deadweight loss. The tariff reliably cuts imports but violates the cost constraint. Neither is clearly superior without knowing the weight the government places on each objective; a judgement that names the trade-off (fiscal cost and leakage versus user cost and regressivity) is stronger than picking one instrument outright.